|
|
· It is
generally agreed that the financial objective of the firm should be
maximization of owners’ economic welfare. However, there is disagreement as to
how the economic welfare of owners can be maximized. The well known and widely
discussed criterion which are put forward for this purpose are: (a)Profit maximization and (b) Wealth
Maximization.
· The terms profit
maximisation is deep rooted in the economic theory. When firms pursue the policy of maximising
profits society’s resources are efficiently utilised. According to this
approach the firm should undertake those activities that would increase profits
and those that decrease profits should be avoided. The PM criterion implies
that the investment, financing and dividend policy decisions of a firm should
be oriented to the maximisation of profit.
· The
reasoning behind profitability maximisation, as a guide to financial decision
making is simple. Profit is a test of economic efficiency. It
provides the yardstick by which economic performance can be judged. Moreover it
leads to efficient allocation of resources as resources tend to be directed to
uses, which in terms of profitably are the most desirable.
· It ensures
maximum social welfare. Financial Management is concerned with the efficient
use of an important economic resource (input) namely capital. It is
therefore agreed that profitability maximisation shall serve as the basic
criterion for financial management decision.
The PMC has however
been questioned and criticized on several grounds. The reasons fall into 2
broad groups.
a). those that are
based on misapprehensions about the workability and fairness of the private
enterprise itself;
b) those that arise out of the difficulties of applying this
criterion in real world situations.
The main technical default of this criterion are as follows:
1. One practical difficulty is that the term profit is a
vague and ambiguous concept. It has no precise connotations. It is amenable to different
interpretations. For example Profit may
be short-term profit or long term profit, it may be total profit or rate of
profit. It may be before tax or after tax, profit per share, operating profit
or profit to the shareholders.
It may be return on total capital
employed or total assets or shareholders equity and so on. If profit
maximization is taken to be as an objective, the question arises, which of
these variants of profit should a firm try to maximise? A vague
expression like profit cannot serve as the basic contains for financial
management decision.
2. Timing of benefits is a more important technical
objection to PM. It ignores the differences in the time pattern of the benefit
received from the investment proposals or courses of action.
While working out profitability, the bigger the better
principle is adopted as the decision is based on the total benefits received
over the working life of the assets, irrespective of when they were received.
Time
Pattern of Benefits (profit)
Alternative Alternative
Period
A B
I 5,000 ----
II 10,000 10,000
III 5,000 10,000
---------- ----------
20,000 20,000
======== =====
It can be
seen from the above table that the total profit associated with the
alternatives A and B are identical. If PM is the decision criterion, both the alternative
would be ranked equally.
But the return from
both alternatives differs in one important respect
-while alternative A provides higher return in earlier
years. The returns from alternative B are larger in later years. As a result
the 2 alternative courses of action are not strictly identical.
A basic rule of financial planning
is earlier the better as benefits received sooner are more valuable
than benefits received later. The reason for the superiority of benefits
now over benefits later lies in the fact that the former can be reinvested to
earn a return, which is defined to as time value of money. The profit
maximisation does not consider the distinction between returns received in
different time periods and treats all benefits respective of the timing as
equally valuable. This is not true in actual practice as benefits in early
years should be valued more than equivalent benefits in later year. This
assumption of equal value is inconsistent with real world situations.
3. Quality Benefits- Probably the most important
technical limitation of PM as an operational objective is that it ignores the
quality aspect of benefits associated with a financial course of action.
The term quality refers to the
degree of certainty with which benefit can be expected. As a rule, the more
certain the expected return, the
higher the quality of benefits.
Conversely the more uncertain or fluctuating the expected benefits, the lower the quality of
benefits.
An uncertain and fluctuating return implies risk to
the investors. It can be safely assumed that the investors are risk
averters, i.e. they want to avoid or at least minimize risk. They can therefore
be reasonably expected to have a preference for return, which is more certain
in the sense it has smaller variance over the years.
The problem of uncertainly renders profit maximization
unsuitable as an operational criterion for financial management as it considers
only the size of benefits and gives no weight to the degree of uncertainly
of the future benefits.
Uncertainly about Expected Benefits (profit)
Alternative Alternative
State of Economy A B
Recession Period I 900 Nil
Normal Period
II 1,000 1,000
Boom Period
III 1,100 2,000
--------
--------
3,000 3,000
It is clear from the table that
the total returns associated with the 2 alternatives are identical in
a normal situation but the range of variations is very wide in B
and narrow in A. The earnings associated with B are more uncertain (risky)
as they fluctuate widely depending on the state of the economy. Obviously A is
better from the point of view of risk and uncertainty. PM criterion fails to reveal this.
Further, the objectives of PM does
not allow for the effect of dividend policy on the market price of
the share. If the objectives were to maximize earnings per share, the firm
would never pay dividend.
To summaries -- PM criterion is inappropriate and
unsuitable as an operational objective of investment, financing and dividend
decision of a firm. It is not only vague and ambiguous but also it ignores 2
important dimensions of financial analysis namely:
(a) Risk and (b) Time value of
money
·
A business unit is not run solely with the objective of
earning the maximum profit possible.
There are firm which are prepared to accept lower profits in order to
have growth in the volume of sales and to have stability. There are some
firms, which undertake project, which may yield lower profits but contribute
to social welfare.
·
Further PM at the cost of a social and moral obligations
and ethical trade practices is not a good business policy. All these
quality aspects of business activities are ignored by the concept of PM.
A firm pursing the objective of PM starts exploiting
workers and consumers. Hence, it is immoral and leads to a number
of corrupt practices. Further, it leads to social inequalities
and lower human values, which are an essential part of an ideal
social system.
It is agreed that PM should be the objective for the
conditions of perfect competitions and in the wake of imperfect competition it
cannot be the legitimate objectives for the firm.
A company is
financed by shareholders and financial intuitions and it is controlled by
professional managers. Workers,
government and society are also concerned with it. So financial management has
to reconcile the conflicting interest of all the parties connected with the
firm. Thus PM as an objective of FM has been considered inadequate.
An appropriate operational
decision criterion for financial management should be:
·
precise and exact
·
based on the bigger the better principle.
·
consider both quantity and quality dimensions of benefits
and
·
recognize the time value of money.
Wealth Maximization Decision Criterion
The financial management decision can be classified into 3
basic kinds-
Investment decision, Financial
decision, Dividend decision.
These three components of the financial functions interact
among themselves in order to attain the objectives of financial management,
namely wealth maximisation.
This is also known as Value Maximisation or Net Present
Worth Maximisation. It is almost universally accepted as an appropriate
operational decision criterion for FM decisions as it removes the technical
limitations, which characterizes the PM criterion. Its features satisfy all
the 3 requirements of a suitable operational objective of financial course
of action, namely exactness, quality of benefits and time value of money.
The value of assets should be viewed in terms of the
benefits it can produce. The worth of a course of action can be judged in terms
of the value of the benefit it produce less the cost of undertaking it. A
significant element in computing the value of a financial course of action is
the precise estimate of the benefit associated with it.
The WMC is based on the concept of cash flow generated
by the decision rather than the accounting profits, which is the basis of the
measurement of benefits in the case of PMC. Measuring benefits in terms of cash
flows avoids the ambiguity associated with accounting profits.
·
Other things being
equal, less uncertain cash flows should be valued more highly then more
uncertain cash flows.
· It
consider both the quantity and quality dimension of benefits and also
incorporates the time value of money. The more certain the expected returns
(cash inflows) the better the quality of benefits and the higher the
value. The terms value is used in
terms of worth to the owner i.e. ordinary shareholders.
· The value
of a stream of cash flows with WMC is calculated by discounting its element
back to the present at a capitalisation rate that reflects both time and risk.
· The
capitalisation (discount) rate that is employed is therefore the rate that
reflects the time and risk performance of the owner or supplies of capital. The
capital rate has a measure of quality(risk) and timing and is expressed in
decimals notation e.g. 15%=0.15. The
higher the risk and the longer the period, the larger the capitalization rate.
The NPW/W Max is superior to the PM.
It involves a
comparison of value to cost.
In the words of Eyra Slomen “the gross present worth of a
course of action is equal to the capitalisation value of the flow of the future expected benefit,
discounting (or capitalised) at a rate which reflects their certainly or
uncertainty’.
Wealth or NPW is the difference between gross present
worth and the amount of capital investment required to achieve the benefits
being discussed. Any financial action which created wealth or which has Net
Present Worth above gross is a desirable one and should be undertaken. Any
financial action, which does not meet this test, should be rejected. If two or
more desirable course of action is mutually exclusive (i.e. if only one can be
undertaken) then the decision should be to do that which creates most wealth or
shows the greatest amount of NPW.
It would also be noted that the focus of financial
management is on the value to the owners or supplies of equity capital. The
wealth of owners is reflected in the market value of shares. So WM implies
the maximisation of the market price of shares.
·
This concept takes into account even the dividend policy
of the company. This concept allows the dividend policy of the company to have
its effect on the Market Value of the equity share. The objective of the WMC is
in total agreement of the objective of
maximising the economic welfare of the shareholder of the company.
·
It serves the interest of suppliers of loaned capital,
employees, management and society. Besides shareholders there are short
term and long-term supplies of funds that have financial interest in the
concern.
·
Short terms lenders, are primarily interested in liquidity
position so that they get their payments in time. The long term lenders get
a fixed rate of interest from the earning and have also a priority over
shareholders in return of their funds. It also ensures security to lenders.
·
WM objectives not only serve shareholders’ interest by increasing
the value of holding.
·
The employees may also try to acquire share of
company’s wealth through bargaining etc. Their productivity and efficiency is
the primary consideration in raising company’s wealth.
·
The survival of
management will be served if the interest of various groups is served
properly. Management is the elected body of shareholders. The shareholder
may not like to change the management if it is able increase the value of
their holdings. The efficient allocation
of productive resources will be essential for raising the wealth of the country.
The economic interest of society is severed if various resources are
put to economical and efficient use.